ESOP: A Four-Letter Word

English now has so many acronyms that the same acronyms are used for very different things. Context typically prevents any misunderstanding. For example, if you’re talking with your friend about basketball, and she says “MVP”, you’ll know she’s probably not talking about a minimum viable product. Confusion and danger arise when the same acronym is used for two things that are very similar but also importantly different.

In the US, ESOP typically stands for Employee Stock Ownership Plan. An ESOP is an IRC section 401(a) qualified defined contribution plan. It is an employee benefit plan that gives workers an ownership interest in their employer. ESOPs have the following characteristics:

• ESOPs only provide equity for employees.

• ESOPs fall under the jurisdiction of both the Internal Revenue Service (IRS) and the US Department of Labor (DOL).

• Shares are typically tied to vesting, where employees earn additional shares for each year of service.

• When a fully-vested employee leaves the company, the firm purchases the vested shares back from them.

• Employees that leave the company voluntarily cannot take the shares of stock with them, only the cash payment.

• Distributions are typically not permitted to people under 55 years of age.

Because of the significant costs of establishing and maintaining one, ESOPs are usually only created for established businesses with long exit horizons.

ESOP is also used to refer to Employee Stock Option Plan. For example, ESOP is used this way on Orrick’s website (sorry Orrick). However, “stock option plans” or “equity incentive plans” are not synonymous with ESOPs. Unlike ESOPs:

• Stock option plans can provide options to both employees and non-employees.

• DOL has no jurisdiction over stock option plans.

• Options are typically tied to vesting, but an exercise price must be paid for the options to become shares.

• When a fully-vested employee leaves the company, they typically have 60 days to exercise their options. If the options are not exercised within 60 days, they are forfeited.

• The security holder’s age is not relevant.

• Stock option plans are relatively easy to create and are often the equity plan of choice for venture-backed startups.

In India and some other countries, they don’t have the US-equivalent of an ESOP, but they do have equity incentive plans that they call ESOPs. This also creates a lot of confusion for employees, managers, investors and service providers for companies with India-US cross-border structures.

Rick Randel of Randel Law also points out that some businesspeople incorrectly use ESOP to generically refer to any form of employee ownership (RSUs, options, phantom stock, etc.).

Our recommendation:

Employee Stock Ownership Plan is way too cumbersome to verbalize with any frequency. Reserve the acronym ESOP for this term, but only use it once you’ve clearly established what type of equity plan you are talking about. Don’t use the acronym ESOP in any other way!

Eric Sundheim, ASA

Principal

Mercovus Valuations